February 4, 2009

The Dismal Scientist

Via DPF, I was fascinated to read this op-ed by Don Brash in the Herald discussing the origins of the current financial crisis (shorter Brash, monetarism and the banking system are fine, but there’s too much government intervention in the free market and that’s what caused all this mess). There’s so much to comment on here but I was particularly struck by this claim:

We also know that, in the nineties, the United States Government started putting pressure on American banks to lend to borrowers of quite marginal creditworthiness to prove that they were not discriminating on the basis of race.

Brash is talking about the Community Reinvestment Act, the theory being that the Clinton administration forced the poor banks to lend money to greedy ‘people of race’ who refused to pay it back. This is a talking point that crops up a lot on right-wing blogs – the boys at No Minister have been regurgitating it ad-nauseum and the subtext is pretty obvious: niggers (and hispanics) are to blame for the sharemarket crash – but it’s been refuted by every mainstream finance or business publication in the world. Business Week have a good discussion of the issue here; Barry Ritzholtz has excerpts from a speech by Federal Reserve Governor Randall Kroszner:

I will also discuss the findings of a recent analysis of mortgage-related data by Federal Reserve staff that runs counter to the charge that the CRA was at the root of, or otherwise contributed in any substantive way, to the current subprime crisis . . .

“This result undermines the assertion by critics of the potential for a substantial role for the CRA in the subprime crisis. In other words, the very small share of all higher-priced loan originations that can reasonably be attributed to the CRA makes it hard to imagine how this law could have contributed in any meaningful way to the current subprime crisis.”

I guess this shouldn’t come as any surprise; under Brash National ran it’s 2005 election campaign on the premise that low-income Maori were the scourge of the New Zealand economy so I can see how he’d be attracted to the idea that poor black mortgagees caused the global liquidity crisis, even if it has been roundly refuted. But isn’t this supposed to be Brash’s area of expertise? Shouldn’t the former governor of our own Reserve Bank be a little more up to speed than the morons at No Minister?

Here’s another revealing excerpt from Brash’s op-ed:

Gould seems not to have noticed that the crisis emerged not in the essentially unregulated hedge fund industry, or even among private equity funds, but in the most highly regulated part of the financial sector, namely banking.

It feels a little hubristic to be nay-saying Don Brash’s expertise on issues like this – but try and find me a reputable history of the sub-prime mortgage crisis that doesn’t state that the crisis emerged when Bear Stearn’s sub-prime hedge funds were wiped out in July of 2007. This isn’t complex, technical stuff, this was a front-page news story that Brash is oblivious to.

Brash is also being dishonest when he points to regulated financial sectors as being the source of the problem; the collaterized debt obligations (CDO’s) that wiped out banks in the US and UK were owned by structued investment vehicles (SIV’s), companies that were deliberately opaque and designed to avoid reglation and government oversight. (The Financial Times has a good overview; I love the narrators lisp).

I guess Brash has – literally – devoted his life to the cult of monetarism, the mystical belief that the market always works and the market is the only thing that works, and at this point in his career there is nothing that can happen in the real world that will prove him wrong. Brash certainly knows about the failure of the Bear Stearns hedge fund but in his mind it’s not important. Somehow, somewhere, government intervention is to blame. It always is.

This happens in the scientific community as well; when a new ‘paradigm’, or model emerges and displaces the old one most scientists adopt the new theoretical framework – but the high priests of the old system rarely if ever do. Einstein never accepted quantum theory, younger geologists had to literally wait for the older generation to retire and die before plate tectonics became a dominant theory.

We’re still going to have true believers like Dr Brash around for a while, just as there are still wild-eyed marxist-leninsts standing on street corners handing out the Daily Worker and insisting that Communism is a great idea, it just hasn’t been tried properly yet. It’s okay to feel sorry for them.

Pity aside, this was a fascinating insight into how insulated Brash is from reality; it sends chills down my spine whenever I think about how close he came to running the country.

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“just as there are still wild-eyed marxist-leninsts standing on street corners handing out the Daily Worker and insisting that Communism is a great idea, it just hasn’t been tried properly yet. It’s okay to feel sorry for them.”

chortle.

it’s funny cause it’s true.

brash’s cognitive dissonance is strikingly familiar to that of douglas regarding his reforms. for instance the ongoing commitment to “tariff-free trade”… that very few countries have followed our lead on.

Danyl: the mystical belief that the market always works and the market is the only thing that works,

But wouldn’t it be nice to try it once? I mean, markets don’t get a chance to work with the governments delightfully spending the taxpayers money of the next 2 generations.

Oh boy, I’m so glad the government run banks didn’t have anything to do with this. There were no court cases forcing banks to lend to certain groups, no federal reserve bank setting interest rates, and no government regulation to speak of.

Maybe you should visit North Korea once, they don’t have any of the things you find so problematic.

Danyl: but the high priests of the old system rarely if ever do.

Sorry to break the news Danyl, but global warming is out. You haven’t caught on yet, you’re still stuck in the old paradigm, and it seems you never will.

It’s been tried lots of times, and always with the result of astonishing economic growth followed by a catastrophic market failure wiping out all the previous gains, at which point the government championing deregulation gets voted out and a new one restructures the economy.

…today we’re hearing the know-nothings blame the subprime crisis on the Community Reinvestment Act — a 30-year-old law that was actually weakened by the Bush administration just as the worst lending wave began. – Business Week link.

I find it entertaining that Aaron Pressman (author of the counterpoint argument listed by someone else on this thread), who holds a B.S. in History from Columbia, is calling Jeffrey Miron a “know-nothing,” who has a Ph.D. in Economics from MIT and is Senior Lecturer and Economist at Harvard University, in addition to the 166 academic economists who were against this bailout. Who else said the CRA is responsible for our current crisis? What’s that, Ron Paul?

Another thing people, if you follow that Bear Stearns link, you will see that this is a case of fraud and deception. Fraud and deception are also caused by capitalism. As well as greed, hunger, poverty, and cancer.

If only we had more government, we would have no fraud, and everyone would pay their taxes.

I don’t understand how you can essentially claim that Don Brash would have thrown NZ’s economy wide open and scrapped all government intervention – given that his career’s work as Governor of the Reserve Bank up until that time had been to act as an instrument of governmnent intervention (and a very effective one at that).

Also, you are a tad harsh on National’s 2005 campaign, which did not run on the subtext that the scourge of our economy is low-income Maoris; it was trying to simply own up to the problem that an economically declining, over regulated, green-taped and financially strangulated economy does not do itself any favours by encouraging a sizeable and ever-growing segment of its population to live of others’ efforts and avoid work.

The solution is (as is often the case) the Middle Path…. but I hardly think Brash was advocating an unfettered free-for-all where the ‘market’ was totally unencumbered by any sort of control at all. The fact remains, though, in my view, that the US and much of the western world relies far too much on unrealistic property values and artificially stirring the money pot around by way of mortgages etc and far too little on productivity. Every time the OCR moves a fraction either way the media go into orgasmic frenzies about what this will do to ‘house prices’ when what really matters is whether or not the country will become more productive or more efficient. There is something badly wrong with an economy which puts more faith in the value of a static non-productive asset like a townhouse in Mt Eden than in, say, a software development start-up with a radical new product which is proven to work but needs development capital.

Frankly, what sends a chill down my spine is how little the new government seems to be actually doing to address the problems of hidebound bureaucracy and green tape in this country. But that is probably not pertinent to the discussion here, which is about Dr Brash’s views some 4 years ago.

Have to call it a day, so this is my last comment for now. Here the New York Post:

A 1995 strengthening of the Community Reinvestment Act required banks to find ways to provide mortgages to their poorer communities. It also let community activists intervene at yearly bank reviews, shaking the banks down for large pots of money. … On the Web, you can still find CRA loans available via ACORN with “100 percent financing . . . no credit scores . . . undocumented income . . . even if you don’t report it on your tax returns.” Credit counseling is required, of course.

And the money quote:

Ironically, an enthusiastic Fannie Mae Foundation report singled out one paragon of nondiscriminatory lending, which worked with community activists and followed “the most flexible underwriting criteria permitted.” That lender’s $1 billion commitment to low-income loans in 1992 had grown to $80 billion by 1999 and $600 billion by early 2003. Who was that virtuous lender? Why – Countrywide, the nation’s largest mortgage lender, recently in the headlines as it hurtled toward bankruptcy.

Sorry, forgot the attribution, this was written by one of the economists Danyl finds it so hard to find: Stan Liebowitz is the Ashbel Smith professor of Economics in the Business School at the University of Texas at Dallas.

Dave” There is something badly wrong with an economy which puts more faith in the value of a static non-productive asset like a townhouse in Mt Eden than in, say, a software development start-up with a radical new product which is proven to work but needs development capital.

Berend, you’ve probably been told this, but when you start invoking North Korea at a time like this it give the impression you need a screw tightening.

It may come as surprise, but it turns out there are many gradations and variations between an anarchist paradise and a completely controlled economy.

Further, it is my own opinion that there are areas where, on diverting far in one direction or the other, Bad Things have happened. I realise that the phase-space of the optimalness of possible economies may not be flat, but I am content with this as a decision-making method.

I find this the interesting quote from Brash: “In retrospect, both monetary policy and fiscal policy were too loose, in the United States at least”
Ahhhh, that “policy” is government regulation, which you’ve said was too loose, yet apparently wasn’t the problem? Lordy.

I have a lot of time for the argument that it wasn’t a problem with the amount of regulation – but the levels set within that legislation and the enforcement of it. Brash unfortunately isn’t making this grey distinction. As they are intertwined close enough to comfortably make the claim that “loose regulation was a major enabler of the problem”.

Che, call me a sceptic, but isn’t the World Bank’s main purpose to enrich Third World dictators and their armies in return for UN ‘votes’ and support instead of actually doing something for the world’s poor? I’m not sure if I would have a lot of faith in anything concerning these people’s ratings – but if our country rates so highly when it can’t dig out massive reserves of coal for fear of diturbing the native snails, then God help the poor people in the rest of the world, mate.

On the subject of ‘mainstream’ New Zealanders; no, the segment of Maori society who think that the productive people of New Zealand owe them a living and they are entitled to continually sponge off society and siphon off our hard-earned money and resources to their own ends are not mainstream New Zealanders. Oh wait… maybe they ARE. Maybe the rot has gone further than I hasd realised – which would explain a lot about where we now are as a country.

I entirely agree the characterisation of Brash as a zealot. His commentary about what “caused” the crisis is far from credible despite his obvious experience. Posner, law and economics professor extraordinaire, was interviewed recently in a podcast to which I subscribe and clearly argued politics was an influence, but not the cause. Instead he argues sustained prosperity and the invention of new investment insurance/securities (the CDOs and SIVs you mention) fueled but didn’t cause the housing bubble and gave false confidence to other investments. Government didn’t fail, avarice financiers did. Though this mightn’t spell the end of capitalism as some argue, Brash is no more credible in his insistance that somehow government is too blame.

Yeah, people have been predicting ‘the end of capitalism’ for about 150 years now; the free market is still fine and dandy. What we’re seeing the end of is the belief that markets have magical powers and that we don’t have to rely on trying to elect competent governments or have ethical, smart people overseeing our mind-blowingly complex economies because the markets themselves will somehow solve all our problems.

So you apparently think that “the segment of Maori society who think that the productive people of New Zealand owe them a living and they are entitled to continually sponge off society and siphon off our hard-earned money and resources to their own ends” is the mainstream segment of Maori society? In which case, you’ve proved Che’s point about National’s campaign. Anyone with iwi affiliations, i.e. anyone who clearly identifies as Maori, must not be mainstream.

Added to which, I suspect you aren’t talking about dole bludging, but rather, Treaty settlements. My God, how dare we treat the people whose country we re-assumed as our own with respect and some attempt at fairness? There’s a reason that Maori are one of the better off indigenous, colonised global cultures. I suppose you’d rather we were more like Australia?

shorter Brash, monetarism and the banking system are fine, but there’s too much government intervention in the free market and that’s what caused all this mess

I don’t think he’s making that argument at all.

What he’s arguing is that the genesis of this crisis happened at a time where there was already significant market regulation – as opposed to Gould who, according to Brash at least, argues that this happened in an environment of unfettered free-market capitalism.

He never said there was too much government intervention. But he did make a number of points about how some regulation had negative unintended consequences – eg false security. Which is an interesting observation and worth taking seriously.

What he did say was “both monetary policy and fiscal policy were too loose” which suggests he’s not arguing against regulation at all but for more efficient regulation.

I would argue that part of the problem is that such policy hasn’t kept up with the way in which computer technology enables clever people to formulate clever financial devices to circumvent reglation while at the same time giving a tremendously fasle sense security – “surely all those hundreds of computer screens with there display of some so many figures and graphs and statistics has to be giving me a Very Good View of Reality”.

Tidhe… I wrote ‘the segment’ deliberately. That is, I was not by any means saying that ALL Maoris think that the productive people of New Zealand owe them a living – far from it – but there is cerainly A segment that do. This is the segment I was referring to.

I would much prefer that we were more like Australia in respect to treaty claims etc. The Australian approach seems to me to say that ‘There is a functioning 21st century here which you are welcome to join if you like, however we will not accept responsibility if you choose to drink yourselves to death, rape and brutalise each other and behave like stone age tribalists.’ This attitude seems far healthier to me than our continual regrets, self-flagellation and bribery to assuage imaginary guilt. All this has done so far is to CREATE a class of people who, 20 or 30 years ago would have been happily getting on with their lives as productive New Zealanders. The result of all this treaty bullshit has been simply to fractionalise and divide our country and it is well past time a stop was put to it.

My God, how dare we treat the people whose country we re-assumed as our own with respect and some attempt at fairness?

Well put. The late Tainui elder, Bob Mahuta, once gave a lecture in which he argued he didn’t particularly mind how Pakeha choose to deal with Treaty claims, so long as they were dealt with. Though the colonisation of NZ was no picnic, we might at least acknowledge that we were last and benefited from slightly more the enlighted attitudes giving rise to the Treaty.

I would much prefer that we were more like Australia in respect to treaty claims etc. The Australian approach seems to me to say that ‘There is a functioning 21st century here which you are welcome to join if you like, however we will not accept responsibility if you choose to drink yourselves to death, rape and brutalise each other and behave like stone age tribalists.’

Dave, I’m mostly just shocked by what you’ve just written. I’m guessing you’ve little real knowledge of Australia’s violent colonisation and the abject depravation of many Aboriginal communities? Fortunately for me, I live in Australia, the Prime Minister and almost every intelligent Australian recognises what you do not; that the Aboriginal people have been brutalised and abused for over two hundred years and the apology they’ve only recently received hopefully marks a change in direction. The attitudes you claim are Australian were recently denounced, I’d advise you to catch up.

Don’t be shocked, Paul. I am perfectly aware that many Aboriginal communities were deprived (not ‘depraved’ as you wrote.. just adding a light note, hahaha…) in historical times. Also, of course, there were terrible examples of Aboriginals being literally hunted down like dogs, in Tasmania for example, and the whole country itself was founded on the inhumane inequities of the British penal system. I do read and I do talk to people; in fact, I have lived in countries (principally in South America) where the colononial powers literally massacred whole races of people to extinction in the name of their religion. It must have really sucked, eh?

My point is, though, that we are decieving ourselves when we A) judge historical actions by today’s standards and morality and B) take on cultural guilt for other people’s actions far in the past which we had absolutely no part in. No Maori living now has been adversely disadvantaged by any action of any colonialist (von Tempsky included) because they weren’t alive then and to wail on and on and thrash it all to death in the 21st century is stupid and counter productive.

I don’t really mind your label of ‘racist’ if that makes you feel better. I’m really glad, though, that my racism doesn’t extend to my burning myself up with resentment at the way my French ancestors were slaughtered by Edward III’s victorious troops in Vironchaux after the battle of Crecy in 1346. Boy, those pommie bastards…. mon dieu!

No, actually Che. I emigrated to this country 40 years ago and I left everything behind (well… my BSA motorbike hahahaha) and worked hard. Then I did the same for a while in Australia and various South American countries before coming back here. I have travelled all over the world and believe me, there is no *poverty* in *Maori* communities. If you want to have a taste of poverty, go have a look at fucking Mumbai, sport. Or maybe, closer to home, the squatters in Nausori. Open your eyes.

Wow, this has turned into a conversation not about what you said Dave – that Aboriginals were rapists and drunks – but whether you have any responsibility for remedial actions. That’s a nice head-fake but how about you start by explaining the earlier comments including this pearler:

There is a functioning 21st century here which you are welcome to join if you like, however we will not accept responsibility if you choose to drink yourselves to death, rape and brutalise each other and behave like stone age tribalists.’ This attitude seems far healthier to me than our continual regrets, self-flagellation and bribery to assuage imaginary guilt.

Functioning 21st century where Mission lands have only longdrops and no power? Where the Police can beat a man so badly they separate his liver and leave him to die in custody? Where long-haul drivers have sex with underage kids for a pack of cigarettes? The dysfunction in some Aboriginal communities cannot be excused by reference only to the history of appalling racism, but you pretend it’s not relevant – both positions are silly, your’s is racist.

I have travelled all over the world and believe me, there is no *poverty* in *Maori* communities.

Sure there’s no one living like they do on the streets of Mumbai, but that doesn’t excuse the enourmous disparity that exists between Maori and non-Maori. Appealing to some absolute and off-shore standard doesn’t change the relative position. There’s irrefutable evidence that Maori were dispossessed of land and resources for generations, a point Che makes, but you think this doesn’t relate to today; how’s that work?

Yes I have and still am a small business owner. I have had businesses for a good part of my working life. Actually, I know your comment above was tongue-in-cheek, but it reminds me of a time when I worked my passage across the pacific on a cargo ship crewed by Kiwis under the thumb of Pommie-dominated seamens’ unionists. As we waited off the Manukau Bar for the tide on the approach to Onehunga I was summoned to the galley by one of the unionists where I was told that I had ‘worked too hard’ and the union would make sure that I never got a job in New Zealand! I nearly died laughing…. (This was years ago, of course, when the Poms ran the unions – Well actually, when there WERE unions to run :-) and when ships from the Islands used to land in Onehunga.

What about, “you want to retire here”? That’s difficult to answer without anticipating a big increase in the labour participation of Maori and Pacific Island Peoples. Fortunately, real gains have been made for both groups, in part, because of strong take-up of industry training (albeit not that strong in SMEs).

I fully agree. The problem for our host (Danyl)and some others is that Brash is someone they have an automatic allergic reaction to. Its not what he says, just enough that he exists.

In this case mr Brash was responding to Bryan Gould who wrote that the crash was the result of unfettered free markets. Mr Brash’s analysis is a good response. I may not agree with all points, by the general argument was strong and well founded.

Your final point is very correct – much of the problems have to do with society failing to keep up with innovation (those flashy screens and maths). The failure of the quants is that there assumptions missed key data such as previous crashes so they only showed prices/risk going up and being mitigated.

Their is significant regulation of the banking system through the Basel Accords but economists are now considering that some of that regulation had the unintended consequences you refer to: 1 it made people feel secure; and 2 appears to have enable regulatory gaming/loading up on products that were favoured by regulation. In this case residential mortgages are counted under existing regulation more positively than other products, so a sensible bank trying to please the regulatory will hold more residential mortgages than they may otherwise have chosen with their economic capital.

Che, to answer your previous question: as you can probably tell from my name, I come from an aristocratic family of the Austrian nobility and, when I was born, my family was on the run in Brasil, dad having been a member of the SS from 1937 to 1945 when his career unfortunately took a turn for the worse. Growing up in Sao Paolo I often went to Argentina as a small boy, where, funnily enough, they used to call me ‘Che’, which, in Buenos Aires is a term of familiar friendship used among young males, much like ‘mate’ or ‘sport’. This, of course, was how Ernesto got his nick.. being Argentinian and all that… but back in those days, everybody called each other Che. Anyway, I digress….

Hey everyone… sorry to have been a party to a change of focus in this thread. I was having such fun that I got a bit carried away.

Anyway, on a serious note, looking back on the comments, I think Hayek (or whatever he would have said) has touched on an important point about Dr Brash. Its interesting how this discussion has moved away from his monetary views and into probably the one area where his forthrightness on race and social issues effectively polarised New Zealand. This, I suspect, was a much more important contribution to the debate on our future as a country, and one which will be remembered long after his contribution to the cobwebbed halls of bean countery has been forgotten.

Don Brash will live long in the memories of Kiwis as either the man who had the balls in Orewa to tell it like it was, or the rabid racist who nearly wrecked the social fabric of the country (depending on one’s view, of course).

Dave, the strength of my reaction is a function of the fact that the Australian of the Year is Prof Mick Dodson who, not so long ago, called for reparations to Aboriginal people and called the NT intervention a police state. My reaction was to your discrediting of Aboriginal grievances cause there’s prevalent alcoholism. That’s idiotic if not racist.

On Brash, I don’t think he is a racist. I think he was a weak leader prepared to do what even Bolger wouldn’t and as much as I blame him, I also hold his idiot adviser accountable too. And has suspicious of Key as I am, I think he’s shown far more insight on race relations than Brash appeared capable of.

Well, Paul, so the population there can now look forward to a swift degeneration of Australia as the cohesive, positive, forward looking lucky country into a new, more 21st century, guilt ridden, self doubting, ashamed and divided society, just like their Kiwi cousins? Wow, that’s progress. ‘Reparations’ eh? Sounds like a perfect lawyerfest… I wonder who will benefit most from this smart new development?

Gareth: I have a lot of time for the argument that it wasn’t a problem with the amount of regulation – but the levels set within that legislation and the enforcement of it.

There was enough, but I think it was Waren Buffet who said that it is very hard to do such regulation if people deliberately set out to deceive you.

Look, for Danyl it’s all simple: this is market failure. If we just appoint another government official who are ethical by definition (how many tax cheats has Obama tried to appoint now? Anyone really believes there are only these four?) and the problem is solved.

But people with some more perspective see that we had an enormous amount of fraud going on as well. Everyone knew they were going to be bailed out. No matter what risk you took. And so it happened. The frauds and the incompetents remain in charge, and the system continues. But not this time I’m afraid. What happened here has little to do with market failure, because if the market was allowed to work, we had seen a few more bank failures where the incompetent were wiped out. But no, the government had to step in to “save the system”. Yeah, the system of fraud and corruption, off-balance assets, kick backs, and what have you.

Che: except the all-too human problem of people exploiting legal loopholes to feather their own nests.

We agree here.

Che: which is exactly why you need effective regulations.

Che, spell out please what regulation was missing here. After Enron we were not supposed to have companies lying about their balance sheet. And for good matters, you may also spell out what regulatino there was that wasn’t effective. That might be a long list.

Neil and What would Hayek provide useful insight, but no one is listening. I bet no one other than they understand each of the linkages from the defaults by the sub-prime borrowers, through to the financial markets freezing up, how and why that has impacted on share markets, how and why it has all impacted on the real economy. But never mind: what Che believes doesn’t change the reality that we face. I’m just a bit shocked that he, and mien host, seem somewhat gleeful at the turn of events, as if they have forgotten that it will be the poorest that bear the brunt.

Note that state regulations in some 29 states absolve borrowers of responsibility for the debt: they can walk away and leave the financier with the house but no right to chase the borrower for any shortfall. The borrower mails the keys to the bank with a note saying so long sucker: the so-called “jingle mail”.

So when you get federal regulation pressurising you to lend to sub-prime borrowers and then other regulations preventing enforcement, it’s no wonder the financiers tried to get the mess off their books via CDOs.

When it is clear that a bank cannot recover some or all of the money lent to a borrower, they “write-off” the non-recoverable amount

Here’s a simple example to try and illustrate what happened to financiers. In this example called Banco.

Shareholders give Banco $200. Depositors give Banco $800. This is a total of $1000. Banco owes these people $1000.

Banco lends the $1000 to homeowners. The homeowners owe Banco $1000. The world is in harmony.

After time passes, the property price bubble bursts.

After further time passes, the homeowners cannot (or choose not to) pay their mortgage, so walk away from their homes and the loans. Banco repossesses the homes and sells them. The sales raise only $750. Banco has $750, but owes $800 to depositors. Forget about the shareholders…
So assets of $750 minus liabilities of $800 equals negative $50. As there is no such thing as a negative asset (as in “that does not compute”) the bank is “insolvent”. If only people were trusting (and patient), Banco could borrow some more money and start doing high quality lending, making $50+ of profits and be in a position to pay back all their depositors. In the meantime, the depositors (and maybe even their children) have died of old age and hell has frozen over.

Now, Banco (and others in Banco’s industry) are not really letting on that they have a shortfall of $50. Everyone knows that they are likely to have lost money on the sale of the homes, but no knows if they got $850 or $750 or somewhere in between. Everyone gets nervous and stops giving money to Banco & mates. (No CDO’s in sight yet).

In fact, it is worse: Banco didn’t get $750 on the sale of the homes: they only sold half of the homes and raised $375. They can’t seem to give the other homes away. So what they do is value those unsold homes using g the data from the sale of the other home. They come up with a value of $375 for the remaining house. Cash + homes = $750.

Borrowers say “please to give us most of our money back. We’d be happy to have 750/800 x our deposit back now = 93.75% of our money.”
“Err, but we can’t pay you back 93.75% right now,” say Banco “as we have only 46.875% of your money…”
“Fine”, say depositors, “sell those $375 worth of house and pay us our 93.75%.”
But of course those houses aren’t really worth $375, because no one seemed to want to buy them.

“Why the fuck did you lend money to people who couldn’t pay it back?” ask the depositors.
“Because the gummint pressured us to (point 1), but also God appeared to us in a dream (point 2) and told us that property values will be going up for quite a while yet, so we’d be sweet-as if there were a default” reply Banco.
“Holy heck, you didn’t put that into your prospectus!” say the depositors “still, some of the defaulters must have other assets, or income you could get your hands on.”
“Err, actually, in these states here, here and here, they don’t let us do that (point 3).” comes the response from Banco.

Depositors say: “Tammy, dear, I’m just off down the Winnebago dealer to cancel our order. Also, we won’t go on that world cruise in the spring after we retire. In fact, we won’t be retiring just yet: close your wallet, dear (point 4)!”

See, lots of points and links. CDO’s are merely one of the vehicles or pathways through which real individual savers/depositors gave their money to financiers who then gave a fair proportion to sub-prime borrowers.

Personally, I think the effect of regulations merely made the problem worse, but didn’t cause it. I don’t even think it all comes down to sub-prime borrowers: cheap money (loose monetary policy) let ALL borrowers compete to bid house prices up to unsustainable levels. We had different regulations in NZ and STILL we all bid up house prices.
And at some point, folk began to get nervous about how much debt their gummints were racking up on their behalf. Remember, there is only one way to pay back gummint debt: tax the workers. So they close their wallets in anticipation. (Well, the gummint could just print the money to repay the debt/fund public services, but that ain’t working out too well for North Korea/Zimbabwe is it?)

But be aware that rising house prices in USA and NZ had very different reasons. Here in NZ we suffer from lack of land, well, not lack of land, the country is empty, but councils make it hard to build, so existing house prices go up, which means councils can rake in greater taxes, which leads to even more regulation, so taxes can become even higher, until the bubble bursts of course.

In the USA we had more a situation like you describe, land regulation was less of a problem. It would be interesting to see how house prices in Houston fared, as they don’t have zoning regulations: did they burst as well? Or largely unaffected?

nice rant clunking, but my even my poor knowledge of this crisis can see you’re deliberately overlooking something.

as neil says above, “I would argue that part of the problem is that such policy hasn’t kept up with the way in which computer technology enables clever people to formulate clever financial devices to circumvent reglation”

my understanding is that the loans themselves weren’t the issue. the issue was the massive leveraging off those loans caused by smart-alec finance companies. the loans to poor people were graded very very low, but these smart-alec’s decided to devise a way to have them regraded so that they *appeared* to be more secure.

they then built a massive house of cards that began to fall when the loans started defaulting, and the false securities, or “clever financial devices”, fell to pieces.

Aw, poo: I forgot to work Fannie (fzztt!) mae and Fat Fredrick Mac into the story, helping create “Moral hazard” in a way that no other english speaking economy replicates. Those 29 states I mentioned earlier: they’re creating moral hazard as well. Borrowers are tempted to borrow just a little bit more, because if they over-reach, they can just shrug their shoulders and walk away. If your credit history is crap already, why would you worry about the “stigma” of default?

The loans, ALL loans, not just sub-prime, are secured over property that no one wants to buy. When everyone’s confidence in the property values and the banking industry is shaken to the core, the vehicle through which money flowed is not overly relevent.
I have friends with 3 properties in the US that agents won’t even list becuase they have too many on their books already. Luckily, they can afford to wait it out.

Look at our own “sub prime”: the finance companies. The circumstances of the lending was somewhat different, but it still comes back to loans that are “secured” over property (hotels, apartments, 2nd-hand cars) that is not worth the balance of the loan, and there is no further assets (due often to limited liabilty of companies involved) beyond the property, some of which cannot be sold. No CDO’s here, yet it all seemed to kick off at the same time (or even before) the US problem became apparent.

Yes, Clunking…. that is a good example you give. I had often wondered at the beginning of the finance companies meltdown here whether this was a forerunner of bigger things to come. Obviously our finace companies and American mortgage lenders aren’t directly connected per se, but the principles must be similar.

Along those lines, Harry Markopolos’s testimony about his inability to get the SEC to respond to his extensive sleuthing on Madoff over the years is must reading.

Markopolos concludes that “”the SEC securities’ lawyers if only through their ineptitude and financial illiteracy colluded to maintain large frauds such as the one to which Madoff later confessed.” This supports my characterization of the SEC in the post linked above as an “accessory” to the fraud.

It is important to recognize that this wasn’t a matter of the SEC simply missing fraudster’s obscure machinations. Madoff’s scheme was designed to fool the unsophisticated regulators he knew would be watching him.

More regulations and better regulators no doubt will solve the problem. Have faith, guys.

But Berend, how can we leave this all to the invisible hand? That’s never gonna work!!

Berend disagrees: if you know that the government will not watch where you spend your money, and that the government will not bail you out, you’re gonna be very, very careful with your money.

We will still have to live with fraudsters, because you can’t detect them that easily. But at least we’re not spending money on regulations and regulators that don’t work either.

“It should be noted that Kevin Rudd had a healthy surplus. Michael Cullen left Bill English a decade of huge deficits.” rants Kiwiblog.
Quick question: remember when all the pressure from the Right was on Cullen to dole out the surpluses in tax cuts, how would we be placed now in this crisis if Brash had won in ’05 and doled out big tax cuts?
(Here’s a clue Kiwis love to take an overseas holiday, buy imported crap or borrow offshore to bid up their neighbours house)

Carlos: tax cuts return money to its owner, to be used for more productive uses. So not only would Cullen have spend so much between 2005-2008 that we got into this mess, but also our tax revenue might have gone up, as it usually does when you decrease taxes, as paying accountants to lower your tax has a lower return, and as said, money is put into productive use, i.e. starting companies that create jobs.

“…tax cuts return money to its owner, to be used for more productive uses.”

“…also our tax revenue might have gone up, as it usually does when you decrease taxes”

Berend is not a reality defying idealogue at all. Not one little bit. The second claim is the most bizarre and indicates that in fact right wing governments should increase tax rates astronomically in order to limit the size of the state. Obviously of course left wing governments should lower taxes to zero as this will give them truly magnficent sums to spend on their evil schemes, like the public health system.

Is this magical inverse relationship between tax rates and revenue constant Berend? You present it as if it’s some sort of law of nature, and therefore must have been observed so many times that we can measure it.

Sorry for just scanning Berend, but if I take the core of that arguments asyou’re gonna be very, very careful with your money
then it’s a question of how careful you want people to be. If one were to deregulate to the point where, say, insider trading stopped being against the rules, I would be keeping my money under the mattress.

Guy – the issue with tax is elasticity. A higher tax rate is often seen to impose higher deadweight costs on an economy resulting in a less then optimal taxation system, with teh effect that ther over tax take is less than it could be. Ramsey optimal tax theory is about devising tax system to generate the optimal level of taxation. What matters is the income-elasticity of the good beign taxed as well as the income substitution effect to determine whether the tax has a progressive or regressive impact. Traditionally higher rates of income tax result in substitution, either by use of debt instruments to fund capital rather than using cash-flow. This results in an overall reduction in the tax pie. In its simplist form it is a suppy and demand response. The higher price (tax) reduces demand. What matters is level of tax compensation received in leiu of the reduced demand. As pointed out above generally higher income taxes encourage substitution at a certain point. IN NZ it can be argued that the 39 cent tax rate encouraged substitution in trusts and property (which has slightly more favourable tax rate). Because these substitutions have costs they are less then optimal for the government where potentially the government might have a more secure and greater pool of taxes due to a lower rate that encourages less substitution.

Now we should also remember that taxation is a form of regulation – it also is not perfect. the question to consider in any regulation is whether it is more optimal than the alternative. In some cases yes in other cases no. Regulation in the finance sector is the same as tax regulation – some rules are valuable where they reduce transaction costs and generate social benefits commensurate or greater than the costs they impose.

So we currently have the right balance in the finance sector – some people say no and with some validity point to the financial crisis.
Now this in no way provides us an indicator of whether the regulatory failure was too much or too little regulation.

Some people say too little and call it market failure others say too much and call it government failure.

The market vs government failure tends to depend on your general political ideological leanings.

What no one is doing is looking at regulatory failure and assessing what gave rise to the regulatory failure and what if any actions can be more optimal to society. Is it possible to regulate innovation? What are the costs and what are the benefits?

At the moment I would say we are still in world of knee-jerk response operating of political prejudice and yet to do any thinking.

What no one is doing is looking at regulatory failure and assessing what gave rise to the regulatory failure and what if any actions can be more optimal to society.

I’d not say no one’s looking at regulatory failure at all. Lots of people are. Former fed Treasurer Peter Costello’s telling anyone who’ll listen why his formation of APRA was so prescient and how the US failure is mostly due to a failure of regulators. Posner too. I think I mentioned up-thread Posner’s argument but it’s quite clear here http://www.becker-posner-blog.com/archives/2008/10/the_financial_c_2.html that he believes failure of regulators was part of the problem.

Low-doc loans (or NINJA as they were callled in Australia; no income, no job or assets) have been limited by APRA, hence the risk reduced. Posner’s argument that solvency, not liquidity, is the issue is less likely to arise where there’s greater underlying value (or at least equity).

Posner also states of the US crisis:

That is the absence of a machinery (other than the market itself) for aggregating and analyzing information bearing on large-scale economic risk. Little bits of knowledge about the shakiness of the U.S. and global financial systems were widely dispersed among the staffs of banks and other financial institutions and of regulatory bodies, and among academic economists, financial consultants, accountants, actuaries, rating agencies, and business journalists. But there was no financial counterpart to the CIA to aggregate and analyze the information–to assemble a meaningful mosaic from the scattered pieces. Much of the relevant information was proprietary, and even regulatory agencies lacked access to it.

And herein lies the problem, the fact of the market is not consistent with the theory. The theory of stock and futures-markets holds that perfect knowledge is possible where clearly it isn’t. A simple example will illustrate this; limited information about margin calls is partly responsible for the rapid collapse of ABC Learning in Australia. This has been, partly.\, remedied – naked short selling too.

Reading the posts above, I agree entirely with you that whether you see fault with the market or with government depends on your ideological lens. And there’s a degree of talking past one another too. I remain of the view that that the failure of regulators and the avarice if financial institutions are the root cause.

Che says “ahhhh… i see. so the new Zealand government forced all those loan sharks to extend loans to people of dubious quality?”

Sorry, I thought I was quite clear: I don’t believe CRA, Fannie/Freddie, non-recourse loans are the CAUSE of the crisis. The bursting of the property bubble is the cause.
95, 100 and 110% mortgages were all the rage in the UK when I lived there in the very early noughties. (I don’t remember 125%, but I guess folk were reassured by Moron Brown’s claim that he had eliminated the cycles of boom and bust that seem to plague fractional banking systems!) Yet the UK has no equivalent to CRA, Fan/Fred, non-recourse…

The regulation just didn’t help. Like not wearing a seat belt doesn’t cause accidents, but it does make it worse…

That just doesn’t make sense. The extent to which NZ is principally impacted by the crisis is as the tide on cheap finance ebbs and global demand shrinks. You might want to take issue with the price Cullen paid for the trains, but the deal itself is no relevant. Interest free loans likewise, you mightn’t agree but it hardly represents a major injection of venture capital (unless you’ve got some theory about how students used the $$).

Also, conflating the housing boom with the entire crisis ignores all the shonky non-housing related investments. How’s the housing bubble relate to Lehman’s failure for instance or the explosion in trading of commodities index funds?

Reducing things to simpification we have problems of:
1. monetary policy settings – either encouraging debt accumulation or increase money supply
2. fiscal policy – execessive stimulus by the government in the economy.
3. regulatory settings (tax as well as regulators and consumer legislation/common law).

First things to clarify – we don’t have “perfect markets” there work within economics on efficient market hypothesis, but this is not the same as “perfect”.

What a market does is reflect the current state of knowledge at a point in time. Hindsight is buyers regret, if only I had bought those microsoft shares, if only I hadn’t invested in Hannover.

So are we arguing to reduce buyers regret (in essence an argument for absolving people from taking responsibility for their decisions) or arguing that there should be an insurance mechanism to enable people to insure against default/poor decision making?

If yes then I have a story of hedging and credit default swops for you. If no then we have a story of pricing risk into decision making.

Both ways we are talking about risk and what are the actions that can be taken to assess, measure and mitigate.

Underlying this is a story of whether we want a risk-free world. What are the signals we provide to the public by removing risk from decision making.

On Posner – yes he is one of the people looking at regulation, but he is one of the few that are not providing a knee-jerk “market failure” response. Posner sees space to advance markets through improving information rather than remove them, which is where a number of people are going with their comments. I do recommend reading the becker-posner blog http://www.becker-posner-blog.com/ and following the debates between these two outstanding economists. There current debate is on american protectionism – both of them are in agreement that it is a bad idea and both support a global market of trade in goods and services rather than skew the markets in favour of artifically protected areas resulting in reduced productivity and higher costs flowing through to greater debt and higher unemployment.

As an aside on market failure – does anyone think trademe is a failure? your local supermarket? probably not, generally I think most people would see them as a highly successful way to provide goods and services.

Now having addressed market failure – lets go and look at the causes of the current problems. A. Monetary policy.In NZ monetary policy is essentially the role of the Reserve bank although the government has some influence. the RB has been running hard against inflation for the past few years despite receiving significant criticism from the property sector and soem exporters as well as some politicians (i.e. Winston Peters). Unlike most of Europe and the US, NZ has not directed monetary policy to lowering interest rates and thereby add additional stimulus into the economy and property market.

Fiscal policy – Treasury budget documents contain a great tool called “fiscal stimulus” which shows the impact of government intervention in the economy. In the past few years treasury has been warning the government and the public that there was a lot of fiscal stimulus going into the economy (also Gareth Morgan). Now what matters (just like mentioned in tax in my prior post) is whether the stimulus is going into increasing productivity to help lean against inflation (pressure on scare resources) by lower cost of delivering goods and services. A high inflation rate that required tight monetary policy by the RB suggests much of the stimulus was inflationary rather than productive, thereby encouraging asset accumulation – assets are a good hedge against inflation.

Now regulatory policy – in taxation there is a slight preference towards property over other assets. Slight preferences matter (see Thomas Schelling and his work on racial dynamics) producing within a short period of time a significant loading of one asset class over another.

So we now have a story of two factors within government control that are encouraging property asset accumulation. If we then add Minskey theory to this (again prior discussion) we have the starting reciepe for problems in NZ. We can also add in changes to the Basel agreements (move from basel 1 to basel 2) which regulate banking/finance which encouraged banks/financers to hold more mortgages (residential mortgages seen by regulators as less risky and so banks given credit for having more of them). So yes we have a regulatory failure, but it is one created from our own settings.

Now I should add to this that in the finance market at the same time we had innovations on risk analysis, whereby the quants using Black-Scholes theory which provides the conceptual framework for valuing options started to develop derivatives helping to spread risk and create credit default products to assist hedging/insuring against loss. What this repricing did was two things:
1. Allow greater leverage due to perceived lower risk
2. Create a few that risk was removed from the market.

Now enter Nassim Taleb and a black swan, actually you didn’t need a black swan, because the market now has a sufficent weight of bad assets (which will always happen), leverage to increase the impact, and regulators and rating agencies supporting a slight preference for these assets you have a cocktail which when consumed gives you massive sugar rush but a really bad come down.

Market failure = yes if you think people are never greedy and there should be no risk.
Government failure = yes if you think the government is all knowing and that the public has no responsibility for who it elects.
Regulatory failure = yes if you think regulators can stay ahead of the armies of lawyers/accountants looking for ways to game the system.

So we should really look back to what are the optimal settings for all three. Generally markets are a good thing but we have to remember that they have risk.

Government has a role to play, but it is a fine balance and needs to watch for the slight preferences it generates that can distort behaviour. On the upside our banking system has generally done well, but non-banks not so good (the finance companies) but a need to remember risk, and sec com, commerce commission and consumer law has been generally good to help keep fraud down.

Monetary policy – In NZ and probably OZ nearly a success story, overseas not so good.

So lets start with what is fixable and have a look at the role of government fiscal policy and regulatory settings including taxation.

In closing – Paul the housing bubble does relate to Lehmans failure, the collapse of the asset bubble produced the eefects described by clunking fist, lehmans ran short of liquidity to meet immediate obligations and therefore tanked.

Commodities is a different story – and is about supply and demand generated from the underlying hot economy which we know was in part due to an asset boom making everyone feel wealthier and that we thought risk was tamed, enabling us to leverage up.

Commodities is a different story – and is about supply and demand generated from the underlying hot economy which we know was in part due to an asset boom making everyone feel wealthier and that we thought risk was tamed, enabling us to leverage up.

My reading is that this is/was not the case, which is why I made my earlier point, and that the index funds’ growth has more to do with money flowing in after the tech crash (plus very active private investors). My point is that there’s multiple factors but not necessarily linked/casual – I note a number of articles invoke the “perfect storm” analogy.

Will agree commodities is a mixed story. Has to do with funds flowing from the tech crash but also to do with rising demand generated from perceptions of growing consumption based economies – which links us back to the asset boom.

So whilst not fully linked, there is a degree of influence. the question becomes whether that degree of influence is enough to over-inflate and already streched ballon.

I’m not comfortable with “perfect storm” analogies but agree there is a lot of multiple factors. I think underlying issue is we got into the demand side of economincs but forgot the lessons of supply side economics. Which might suggest that to get out this current mess we need to focus on the supply side (productivity). Now before anyone jumps on this being a Freidmanite prescription we should take some lessons from the 80’s, recognise that Australia handled the reforms better but still did reform. So lesson for NZ is some reform is needed, but we need to stage reform carefully. Don’t through babies out with the bath water. Otherwise we risk getting into “there is no alternative situations”.

I think fundamentally today, NZ is better placed than it was in the 80’s to progress reforms and at the same time provide support (possible argument for investment in education) for workers who may need to retrain whilst the economy is regearing itself away from excessive consumption.

We need to be smarter in our policy design this time to get us back on our feet quicker. Sometimes smarter also means not reacting based on knee-jerk political prefences. Lets used some empirically based policy in conjunction with support mechanisms.

But we have to recognise there is risk in life.

Enjoy the weekend – good debate helps sharpen good policy design and possibly be better for us all.

Paul Williams at 79: My point was loose fiscal policy. With Cullen, we had a gummint set on growing govt expenditure as a % of the economy. Remembering that it is the (relative) shrinking private sector that pays the taxes, at some point, the tax collected would be insufficient to cover that govt spending. That day has arrived. I think some folk have a problem believing that you can run a surplus whilst operating a loose fiscal policy. It comes done to the sustainability of the spending.

So, with most western gummints borrowing to spend and most central banks allow consumers to borrow relatively cheaply, the developing world’s savers were effectively injecting money into our economies. That money had to go somewhere and this time it seems it mostly went into property.

And a racist poster earlier posted in this thread that they thought Brash gigalow used his balls in a brave way.

His balls had nothing to do with him cynicaly ( not bravely ) stirring the racist pot in an attempt to get the natianals elected ( but what an arsehole of a thing to do ), brashes balls were only of use to him in his serial screwing around on his wife’s ……………… but not in a anti-family way you understand.

There is no such thing as “poor black mortgagees” or poor white mortgagees.

People paying mortgages are mortgagors, the mortgagees are on the other side of the contract.

A nitpick, perhaps, but the distinction between mortgagee and mortgagor is one of the most common pair of words people get wrong, as the terms are rarely used in common speech and thus are understood by few outside of real estate.